The complex puzzle of emerging markets

The emerging market story is a puzzle with many pieces. From an overall philosophical standpoint, the demographic and economic shifts are obvious reasons to have a weighting to emerging markets. But the complexity comes into play with the question of how to invest.

Investors can consider private equity, property and other direct investments as a way of investing in emerging markets, but it is via the three main areas of debt, equities and currency that most of the action occurs.

Within fixed income there has been a recent structural shift that has implications for the way investors view the asset class, and its correlations.

Emerging market economies – a structural reduction of risk, a paper by Neuberger Berman’s Alan Dorsey, Juliana Hadas and Parth Brahmbhatt, outlines emerging-market sovereign-debt issuers have migrated to investment grade credit, which has meant that emerging market debt as an asset class has seen a reduction in its correlation to non-investment grade corporate-debt indices and an increase in its correlation to investment grade indices.

This means hard currency, or dollar-denominated emerging market debt, is trading at a much lower risk premium versus high yield than it has historically.

Secular, not cyclical

The paper outlines the possibility that this risk premium compression is secular, not cyclical.

In other words, it may be a one-time transformation in the perceived “riskiness” of the emerging debt asset class.

Co-head of Neuberger Berman’s emerging market debt team, Gorky Urquieta, says the detail of this structural transformation is seen by looking at the comparison of external debt to domestic debt in emerging markets, as well as the emerging markets compared to developed markets.

“It is clear how there is a divergence, with emerging market debt to GDP at 40 per cent and declining, while developed markets is around 100 per cent and increasing,” he says.

There has also been an increase in local demand for emerging market debt, with debt rotating from external to internal, especially in countries such as Russia and Brazil, which has contributed to economic growth and the stabilisation of debt markets.

“Emerging markets are net external creditors – they have more assets than liabilities – that provides them with a significant buffer,” he says. “The dynamics are better than in the developed world, and achieved on much higher growth rates and better management of fiscal accounts.”

Performance matters

Emerging market debt issuance is at record levels, in both issuance and dollar value, as investors seek new markets with the prospect of enhanced returns in the low interest rate environment of developed markets.

Flow data shows there has been an estimated $17 billion of inflows into emerging market debt in the year to mid-March with a bias towards emerging market local currency and emerging market corporate funds.

Dealogic, an investment banking platform, reports that in 2012 the deal value of emerging market debt issuance was close to $900 billion and for the first quarter of 2013 that was already over $300 billion.

In size, it is now comparable with the US treasury market.

At a time in which investors have been desperate to find investments with decent yields, emerging market debt was a logical choice given the robust underlying fundamentals of the asset class.

Emerging debt has seen strong performance and in the 10 years to October 31, 2012: the average annual total return was 11.34 per cent based on the JP Morgan EMI Global Diversified Index, making emerging markets the best-performing fixed income asset class in the period.

But investors around the world have typically had low allocations to the emerging market fixed income space, US investors for example have around 2 to 3 per cent in emerging markets.

“In the context of any measure, it is extremely inadequate,” Urquieta says.

Historically the concerns have been around transparency and the size of these markets which has fed ultimately into liquidity concerns.

“If there is risk-off, then emerging markets are still risk assets; there is no mechanism for sovereign defaults. And corporate recoveries are lower than in the developed world,” Urquieta says.

Yield and structural shift

But with risks there can be opportunity.

Phil Edwards, principal at Mercer in London, says emerging market debt has gone through a transformation in recent years.

He says in 2009-2010 there was interest when yields looked attractive, especially compared to developed markets, and allocations grew quite quickly.

A Mercer survey shows that 13 per cent of European funds have an allocation to emerging market debt, with the average allocation about 5 per cent of total assets.

“Even though yield has come down materially, there is still a case for investing in emerging market equities and debt,” he says. “There is a crossover element. We have seen some, but not many, investors making use of emerging market multi-asset funds. Our preference is to access specialist expertise in each space because they are different and need different skills.”

Edwards is intrigued by the “interesting characteristics” in emerging market credit.

“Funds are seeking exposure through the same emerging-market-debt mandates but broadening it to credit, expanding mandates to allow managers to go into credit.”

The €140-billion ($183-billion) Dutch fund, PGGM, has about 5 per cent of its total portfolio in emerging market local currency debt, which relatively speaking is an overweight position.

It says that while risk premiums have decreased, markets have grown, there is more liquidity, and fundamentals have improved across deficits, debt and policy.

This means that both risks and rewards have decreased, but the giant fund still says there is added value for emerging market debt in local currency because yields are still substantially above developed market yields.

Within emerging markets there has been a structural shift away from sovereign to corporate credit. On average corporates are better rated than sovereigns (see JPM index) and more than half of the assets are investment grade.

The fixed income portfolio of the $65-billion Washington State Investment Board is positioned to take advantage of the structural shift in emerging market debt.

While it doesn’t have a set allocation to emerging markets debt, it currently has about 36 per cent in emerging and frontier market debt, about half of which is in non-denominated bonds.

This is a significant overweight position compared with the Barclays Universal benchmark which is mostly developed market bonds. (Incidentally Barclays has 12 specific emerging market bond indexes).

In addition, the WSIB portfolio has a lot of corporate debt, which it started building in the mid-1990s, and executive director Theresa Whitmarsh says the team is agnostic to geography, rather it looks at macroeconomics, fundamentals and valuation, alongside its own judgement.

“Emerging markets have a great growth story, great demographics, urbanisation trends and fiscal strength. Following the Asian crisis they had to put their fiscal shops in order, and they did, and they are in good shape.”

The WSIB bond portfolio has about 70 per cent exposure to corporates overall, and within emerging markets fixed-income allocations, only two of the top 10 holdings are sovereign debt.

What will emerging markets become?

The emerging markets secular trend of improving fundamentals, has different ways to play.

Emerging markets equities is one way, currency another, risk premium on emerging markets sovereign or credit or a combination, another.

Rob Drijkoningen, co-head of emerging markets at Neuberger Berman, says that in the early 1990s investment grade was a negligible part of the index, now 56 per cent is investment grade.

“It has become less volatile and credit quality has improved,” he says.

In addition, local yield curves have developed, which could create a credit culture, leading to the need for a benchmark culture, and then the pricing of other products.

“We are seeing the establishment of local yield curves,” he says.

Head of investment strategy and risk at Neuberger Berman, Alan Dorsey, acknowledges low yields but says spreads are not at all-time lows.

“Global monetary policy created low yields, but investors still need to make money, beneficiaries still need to eat. Where do you go to get that money and provide that food?” he says.

Dorsey believes emerging market debt is still something of an inefficient asset class especially if corporates are included.

And Drijkoningen believes emerging markets corporations are under-researched and undervalued.

“The market is similar in size to US high yields, but in emerging market corporates the opportunities have a long way to go.”

“The expansion of names and size is interesting,” he says.

While most investors are still looking at emerging markets as one asset class, Urquieta believes in three to five years’ time there might be the low/high investment grade split in mandates.

“For example, in the corporate universe we will see investment grade or high yield exposures. Those types of enquiries, such as investment grade only mandates, are taking place.”

It is possible in the future that mandates will look like a best-idea investment-grade mandate across emerging markets and developed markets.

But a word of warning from Moodys says that assessments of corporate credit risk in emerging markets can also be affected by broader sovereign risk considerations, given the strong links between corporates, financial institutions and sovereigns.

This means that determining risk credits will rely more on qualitative rather than quantitative assessments.